Stop Losses: Where To Draw The Line?

Originally published on Equities.com, October 17, 2016.

I love the phrase “drawing a line in the sand”. According to Word-Detective.com, a possible origin for the phrase is an incident said to have taken place during the siege of the Alamo in 1836, when William Barret Travis drew a line in the sand with his sword and urged those willing to stay and defend the fort to step across it. Great imagery, but then again, history tells us what happened to the Alamo. As investors, one of the most common mistakes that people make is not knowing, or not being willing to draw a line in the sand when it comes to their losses in their portfolios or in individual stocks.

What does it mean to "draw a line in the sand"? Simply put, it means knowing how much you are willing to lose in an investment or in your portfolio before bailing out. Too often, investors operate under the belief that “it will come back,” and that is simply not always the case. Let’s first look at individual equities as an example. In the individual equities markets there are hundreds, if not thousands, of viable stocks for someone to use as an investment opportunity. No matter the company, they all go through a similar pattern: Startup, growth, maturity, stabilization and ultimately decline. Some companies take a few short years to go through this cycle, and some of them take decades. Ultimately, they have the same outcome. Certainly, there are the companies like Disney (DIS) and Amazon.com (AMZN) that always seem to go up, but for every Disney and Amazon, there are plenty of Alcoa (AA), U.S. Steel, Bank of America (BAC) and Citigroup (C). Large, seemingly strong companies that have been unable to see prices anywhere near previous highs. I am certainly not saying that investing in these stocks is always bad; rather, we need to know when it is time to get out of an investment to manage our own personal risk.

There is a lot of negativity around the use of stop losses from short term traders that place them too tight or in the wrong areas, but a stop loss is akin to a seat belt in a car. The seat belt will never keep you out of a wreck, but it is designed to prevent catastrophic results. A stop loss will never guarantee profits, but it will often serve to prevent catastrophic losses. One important element of stop losses, however, is to move them and to create a new “line in the sand” as prices start rising. By doing this, investors stand to profit from rising stocks, but will have some protection in case of a correction. Due to the nature of stocks being only one company, there is inherently more risk. Something like the BP (BP) Deep Water Horizon accident or a battery fire for Tesla (TSLA) can cause great swings in the stock; so, an investor can reduce that risk by investing in the whole market using ETFs or often times the less preferable method of mutual funds. By using a diversified portfolio, there is inherently less risk than in owning the individual stock... but also less reward.

The real question is where to draw this line in the sand and when to move the line. To understand this, one must understand the mechanics of the markets. Markets move due to an imbalance between buyers and sellers. A lack of sellers and an abundance of buyers at a particular price point creates a Demand Zone. This Demand Zone (very different than tradition technical analysis support) will be created when the state of balance ends and leaves unfilled buy orders in its wake. Look at the two charts below. The chart on the left is a picture of the previous demand zone on a monthly chart, giving a clear spot for the "line in the sand". This "line in the sand" is a distance far enough from price that it will not “wiggle” out longer term investors, but is also close enough that longer term investors will not suffer catastrophic losses if the market moves against them. The chart on the right is a picture of a more recent demand zone, and is a closer "line in the sand". The key is that the "line in the sand", or stop loss, gets moved when price creates new levels. By continuing to move price as the market goes up, investors can lock in profits and control catastrophic losses.

How to determine where to place your stop loss.

How to determine when to move your stop loss.

These unfilled buy orders will keep price above the demand zone, and as long as these orders are intact prices will continue to rise. Finding these demand zones on weekly and monthly timeframe charts is the key to knowing where to draw lines, and seeing these zones tells us when to draw these lines.

Originally published on Equities.com.

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